US Fed tightening campaign ‘likely over’

The compounding effects of higher rates and consumer prices ultimately will stifle the labour market and the economy, flipping the Fed.

“The Fed’s inflation and labour market concerns are overstated, and additional rate hikes won’t be necessary. Continued progress in controlling inflation prompted the Fed to once again hold interest rates steady at a 22-year high. [Last] Wednesday’s decision marked the Fed’s second consecutive pause — and the third overall — in its 19-month tightening campaign.

“The Fed paused despite robust economic growth, suggesting the government’s latest GDP data may reflect an anomaly. In its first estimate of third-quarter economic output, the Commerce Department reported the economy grew 4.9 per cent (annualised), the fastest pace in nearly two years. But the surge was largely due to consumers’ summer spending sprees and a jump in inventory investments, which likely aren’t sustainable.

“A still-strong labour market and persistent above-target inflation have largely accounted for the Fed’s hawkish tone. However, since raising short-term interest rates to a range of 5.25 per cent–5.5 per cent in July, policymakers have adopted a wait-and-see approach to additional increases. The compounding effects of higher rates and consumer prices ultimately will stifle the labour market and the economy, flipping the Fed.

“While the Fed left its future policy options open, the central bank’s tightening campaign is likely over. With Treasury yields soaring recently to 16-year highs, the bond market is doing its part, alongside the Fed, to tighten financial conditions. The yield on the ten-year Treasury note, a benchmark for mortgage and other consumer lending rates, recently topped five per cent for the first time since 2007.

“The labour market is a main factor guiding the Fed’s holding pattern. Resilient job creation and the relatively low unemployment rate continue to fuel inflation worries and complicate its interest rate outlook.

“Mounting conflicts between management and labour underscore an unfolding structural economic shift over the coming years. Growing demands for higher wages across industries will likely reshape the capital/ labour relationship to favour labour over capital.

“This pending dynamic also supports our long-term inflation view. With labour taking precedence, inflation likely will settle higher than the Fed’s current two per cent target. We expect this trend to emerge over the next three to five years and persist from there.”

By Charles Tan, co-chief investment officer – global fixed income